Volatility, Intermediaries and Exchange Rates

45 Pages Posted: 20 Nov 2016 Last revised: 4 Oct 2018

See all articles by Xiang Fang

Xiang Fang

University of Pennsylvania, School of Arts & Sciences, Department of Economics

Yang Liu

The University of Hong Kong - Faculty of Business and Economics

Date Written: September 6, 2018

Abstract

This paper studies how time-varying volatility drives exchange rates through financial intermediaries’ risk management. We propose a model where currency market participants are levered intermediaries subject to value-at-risk constraints. Higher volatility translates into tighter financial constraints. Therefore, intermediaries require higher returns to hold foreign assets, and the foreign currency is expected to appreciate. Estimated by the simulated method of moments, our model quantitatively resolves the Backus-Smith puzzle, the forward premium puzzle, the exchange rate volatility puzzle, and generate deviations from covered interest rate parity. Our empirical tests verify model implications that volatility and financial constraint tightness predict exchange rates.

Keywords: Volatility, Financial Intermediaries, Exchange Rates, Currency Risk Premium, Value-at-Risk

JEL Classification: G15, G20, F31

Suggested Citation

Fang, Xiang and Liu, Yang, Volatility, Intermediaries and Exchange Rates (September 6, 2018). Available at SSRN: https://ssrn.com/abstract=2872904 or http://dx.doi.org/10.2139/ssrn.2872904

Xiang Fang

University of Pennsylvania, School of Arts & Sciences, Department of Economics ( email )

Suite 150
133 South, 36 Street
Philadelphia, PA 19104
United States

Yang Liu (Contact Author)

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

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